Calculating Required Rate of Return for Your Field Service Business
As 2017 is drawing to a close, we have been writing and putting together many different blog posts that contain business advice and links to articles, small books, and worksheets that can help you better manage your field service business’s finances in 2018. For example, at the bottom of this blog post, you can download a worksheet that shows you the ins and outs of calculating required rate of return for your company, and how you can save your business money by utilizing field service management software.
However, before you download the worksheet below, take a few minutes to read through this brief post on the basics of calculating required rate of return for your field service business. We want to provide you with a short introduction to the concept, and make sure that someone within your company is aware of how it works, and how to use it to save your business money and in turn, boost revenue.
What exactly is a required rate of return? In the accounting and financial world, the required rate of return is defined as, “The minimum return an investor will accept for a particular investment.” The easiest way to think about this concept in relation to field service businesses would be this example:
Your field service business buys something—e.g. a piece of shop equipment, a vehicle, or a new warehouse building.
You figure out how much money your company needs to make from this item or building in order for it to be a good investment.
*You can also think about hiring—amongst other aspects of your business—that will have an impact on your cash flow for field service.
As you read through this post, keep in mind that calculating required rate of return is different for each field service business, and is truly a subjective number. Think of it in terms of betting on a coin toss, where the odds of winning the flip are 50/50. You must ask yourself the following questions:
What would my business need in return to bet on that coin flip?
How much is my business willing to risk on this bet?
Just as everyone’s risk tolerance is different, so is every field service business’s required rate of return.
However, when it comes to calculating required rate of return for field service businesses, there are some items that are safe bets. For example, having your company invest in field service software is a sure bet when it comes to effective, worthwhile purchases that save your business money in the long run. In fact, we believe that the risk is so minimal when it comes to purchasing field service software that it is more accurate to classify the computer program as a competitive advantage that allows you to boost revenue and save money.
Although investing in field service software seems like a simple option when calculating required rate of return for your business, we understand that companies tend to hesitate before spending money where there is not a precise dollar figure that will be poured back into your business’s bank account. This is where the risk element comes into play because no field service business’s required rate of return will be the same when it comes to purchasing field service software.
Here is a quick, three-stage tutorial on calculating required rate of return when you are deciding whether or not to purchase field service management software for your business:
Stage 1: Calculating CAPM
The first thing you need do when calculating required rate of return for your field service business is create a capital asset pricing model (CAPM) to determine the equity cost. Here’s the formula:
CAPM = Risk-free rate + Beta (Market return – risk-free rate)
(For more about finding risk-free rate and beta, click here.)
CAPM is based on the assumption that buying a riskier asset like larger-than-required trucks or warehouse properties will yield a higher return, which is not always the case. This model is based on how much of a financial risk you are willing to take, as the final calculation is merely an estimate. Therefore, if you are hesitant when it comes to investing, overstate the CAPM value and compare the potential desired investment to a higher rate of return. Once, you calculate the CAPM of an asset purchase, you are halfway toward calculating required rate of return.
Stage 2: Calculating the Cost of Debt
This step is fairly easy when it comes to asset purchases. It’s simply the interest rate on the company’s debt obligations. If your field service business has two or more debt obligations, calculate the weighted average of those obligations.
Stage 3: WACC
The weighted average cost of capital (WACC) may be considered the same as calculating required rate of return. That being said, “How do you get WACC?”
Simply take the equity cost from stage one and the cost of debt from stage two, and combine them to find a weighted average. That number is the fiscal value that your project must exceed for it to qualify as a viable investment. For example, if your company invests in field service management software today, your company will be receiving benefits not only today or this year, but for years to come. If your business calculates a WACC—which is also the rate of return—of 20%, and you spend $100.00 on the software today, your company must make $20.00 of present value money by the end of the investment for it to be worth it.
On the same note, the money you spend buying field service management software has more value today than it ever will in the future. Why? Because money in your pocket or that your business is spending today has the power to create more money in the future. Therefore, future money is not worth as much as today’s money. Today’s money needs to create value in the future at the rate of WACC for it to be a solid investment.
More than likely, your field service business has been crunching different accounting and financial figures for years, and have good understanding of how monetary processes work. However, the landscape is changing, and software purchases and mobile apps are factors that must be factored into overhead costs. Field service management software is one of the most effective ways to integrate your company’s data. The worksheet below is helpful in calculating required rate of return and cost savings when it comes to purchasing field service software for your company.
Any other fiscal questions? Give us a call today—we would be glad to help.